A Look at ABL Markets in Canada for 2010
This outlook for the market for asset-based loans in Canada was drafted by Scott Horner in January, 2010.
Canada has experienced some economic turbulence as a result of the recent global economic crisis. However, Canadian banks have not suffered the losses experienced by many of their competitors in the US and European markets and their stability was not an issue during the financial crisis that has occurred in other markets. The reasons for the Canadian banks’ stability in the face of the financial crisis elsewhere are beyond the scope of this article. However, the banks’ stability; demand for the ABL product to fill the void created by cash flow lenders tightening credit availability; some US lenders repatriating some of their resources from the Canadian market in order to focus on resolving problems at home arising from the recent financial crisis there; and the ABL product working well with an active high yield bond market to fulfill issuers’ capital requirements have contributed to steady Canadian asset-based lending activity for lenders in the ABL business.
Factors Driving ABL Employment
One of the significant strengths of the ABL product is that it can withstand earnings volatility. The key to ABL’s employment is that the borrower owns quality current assets. Accordingly, the product works well with capital intensive businesses like retail, distributors and industrial manufacturers regardless of these businesses’ decreased earnings, or even losses, as a result of the recent recessionary period. Another significant strength of the ABL product is the flexibility that it may afford borrowers by way of its “covenant lite” aspect which may be appealing to borrowers whose financial performance has been adversely affected by the recent recession. Recent Canadian consumer surveys have shown consumers are increasingly confident about their employment, specifically, and about economic recovery, generally. We expect demand for the ABL product will further strengthen during the ongoing economic recovery as borrowers build inventory stock to satisfy increasing domestic consumer demand.
Risk Reward Profile of ABL for Borrowers and Lenders; Impact of Legal Developments on Such Profile
For borrowers, the ABL product can fill a void left by cash flow lenders tightening credit availability if they own quality current assets and provide needed flexibility because of its “covenant lite” feature and no amortization aspect. For lenders, deal structures and pricing are more rational in the current market relative to 2007. In fact, it would not be surprising to see some aggressive pricing from some lenders who view the current market as an opportunity to make up some of the losses suffered in their other businesses during the recent economic downturn.
In terms of legal developments that might affect a borrower’s borrowing availability in an ABL financing, Canadian law now provides for certain wages and pension contributions to have a super priority charge on a borrower’s assets. As a practical matter, however, lenders usually expect that payroll arrears will be paid in insolvency proceedings in order to ensure employee cooperation and, therefore, include payment of such amounts in their liquidation analysis. Subject to certain limited exceptions, interest paid to foreign lenders under a revolving credit is no longer subject to Canadian withholding tax which has facilitated the supply of the ABL product to Canadian borrowers.
Predicted ABL Activity from 2010 Onward
Asset-based lenders understand up and down economic cycles and have demonstrated in the past that they are adaptable to recessionary periods. If history is a guide, an economic recovery period is often best for the ABL business. Scott recalls, approximately fifteen years ago, that he acted for the finance arm of a multinational corporation which had created an ABL unit in response to an earlier economic downturn that had significantly and adversely affected its cash flow lending and merchant banking businesses. This lender experienced some resistance by its cash flow and merchant bankers to moving into ABL because of its negative stigma. However, the ABL unit quickly became a continuing top profit centre for the corporation which vitiated a lot of the initial internal negative stigma associated with the ABL product.
A recently published survey of mid-market corporate CFOs shows that a majority of their corporations expect to require financing in 2010 primarily for working capital and capital expenditure purposes. The relatively strong Canadian dollar should be an impetus for Canadian corporations to make capital expenditures. On the other hand, Canadian exports will be relatively more expensive as a result of the dollar’s relative strength and, therefore, our economic recovery in the near term likely will depend upon domestic demand. In addition, PE financial sponsors seem to be more positive of mind and are looking to pick up new acquisitions in light of the opportunities presented by recent valuation corrections. The ABL product can be expected to be a financing solution seriously considered by some of those CFOs and PE sponsors. We expect ABL activity to strengthen, if not flourish, in the near to medium term. Deals are expected to have more rational structures and pricing. With fewer ABLs in the market as a result of some industry consolidation and some US ABLs having repatriated some of their Canadian resources, lenders in larger deals are expected to hold relatively greater commitments. We also expect continuing ABL activity in the form of “amend and extend” transactions and some DIP financings by some borrowers engaged in industries that were “out of favour” before the economic crisis began or who are unable to recover from the economic downturn without the assistance of insolvency proceedings. We are looking forward to assisting our clients with this business!
